Warning Signs for China as Fed Hints at Curbing Stimulus

Chinese factory activity shrank in May for the first time in seven months, overshadowing signs that the eurozone's downturn tempered slightly in May, business surveys showed on Thursday.

World stock markets tumbled after the Chinese data and also in response to U.S. Federal Reserve Chairman Ben Bernanke, who hinted on Wednesday the Fed could soon pare back its bond-buying with new money if the economy maintains momentum.

Even though the decline in eurozone businesses eased off a little, the PMIs showed a chronic lack of new orders will inhibit any meaningful recovery for some time.

While U.S. data later on Thursday are expected to show manufacturing growth continued in the world's largest economy through May, that is unlikely to counter the uncertainty stemming from Bernanke's comments and the weak Chinese data.

The flash Chinese manufacturing PMI for May fell to 49.6 from 50.4 in April, slipping under the 50-point level demarcating expansion from contraction for the first since October.

"Hopes of a significant recovery (in China) are looking misplaced, but on the other hand the European numbers are slightly stronger than the consensus expected," said Andrew Kenningham, global economist at Capital Economics in London.

"So if you look at the global picture overall, it's slightly weaker than expected, but not dramatically so."

The downturn sharpens Beijing's policy dilemma over whether to act to stabilize activity, or tolerate an orderly slowdown while focusing on reducing the country's dependence on exports and investment for growth — changes that would bring longer-term benefits.

Yao Wei, economist at Societe Generale in Hong Kong, said the debate favors policy inaction from Beijing for now, as long as economic growth remains above 7 percent.

"We don't think it will trigger any cyclical policy move as long as the job market is fine," she said. "China is really on a path of structural deceleration. It's possible (to meet the growth target) but it's becoming increasingly difficult."

The data, coupled with hawkish comments from Bernanke, pulled MSCI's world equity index down 1.25 percent, with Japan's Nikkei index plummeting by more than seven percent.

LIGHT AT THE END OF THE TUNNEL?

The eurozone PMI suggested the bloc's economy is likely to contract again in the second quarter.

Markit's flash Eurozone Services PMI, which surveys around 2,000 companies ranging from major banks to caterers, rose in May to 47.5, a three-month high, from 47.0 in April.

While that was a little better than economists polled by Reuters expected, the PMI has now spent 16 straight months below the 50 mark that divides growth and contraction.

"We see this as confirmation of our expectation that the eurozone economy will end its downtrend in the spring," said Christoph Weil, analyst at Commerzbank.

"That said, a noticeable recovery is still not in sight; the economy will only grow slightly in the coming quarters and it will continue to feel like a recession."

Overall, survey compiler Markit said the surveys pointed to a similar economic performance in the second quarter as the 0.3 percent contraction the eurozone logged in the January-March period.

That is in stark contrast with the United States, where there have been clear signs of growth, raising the prospect that the Federal Reserve could scale back its $85 billion in bond buys each month in its "next few meetings," according to Bernanke.